When you sell an investment property, the tax bills from capital gains and depreciation recapture can be quite large. Especially if you've held the property for a long time. A 1031 exchange eases that tax burden by allowing you to sell the property, use the funds to acquire a new one, and essentially shift all of your tax liability to the new property.
But a 1031 exchange is a complex process and you can’t complete one by yourself. You’ll need to use a qualified intermediary (QI) to set up and make the exchange for you. As you might imagine, this costs money. Here’s a rundown of the costs you can expect when you complete a 1031 exchange with an investment property.
What does a qualified intermediary do?
An IRS-compliant 1031 exchange needs to be facilitated by a third party -- your QI, who will charge a fee in exchange for facilitating the transaction.
The intermediary will:
- Acquire the property from you and transfer it to the buyer,
- Hold the funds from the sale until a replacement property is identified,
- Acquire the replacement property from the seller, and
- Transfer the replacement property to you.
How much does a 1031 exchange cost? The short answer
The direct cost to you in a 1031 exchange typically comes in the form of a fee paid to your QI.
QI fees vary, but most reports indicate that a typical deferred 1031 exchange costs between $600 and $1,200. Certain incidental expenses may also be passed on to you. For example, the QI might pass on an overnight delivery charge if documents need to be sent quickly.
This is for a simple deferred exchange, where you sell a property and acquire a replacement property at a later date. More complex deferred exchanges can cost more.
Interest income: How a qualified intermediary makes most of their money
The setup fee charged by a QI is generally the only major 1031 exchange expense that you’ll pay directly. But it only accounts for about one-third of the QI's revenue.
The bulk of a qualified intermediary’s revenue comes in the form of interest income. When you complete a 1031 exchange, the proceeds from the sale of the original property are held by the QI until you buy the replacement property.
In the meantime, the funds are generating interest in a money market or other deposit account. And the QI keeps some or all of this money.
This can be quite a bit of money since you have 180 days from the date you sell the original property to close on its replacement. Let’s say you sell a property for net proceeds of $500,000 and take the maximum allowable time. If your QI holds the funds in a savings account paying 2% interest, this translates to $5,000 in interest income.
Expect a higher fee for non-standard 1031 exchanges
The fee range I mentioned above assumes you have a simple deferred 1031 exchange that consists of selling one property and buying another one. If your 1031 exchange is more complex, you could pay a lot more.
For example, selling or buying multiple properties can come with extra fees. It’s not uncommon for a QI to charge an additional $300-$400 for each extra property involved in the exchange.
If you complete a reverse 1031 exchange -- buying a replacement property before you sell the original property -- the fee can be several times greater. Not only is a reverse exchange a more complex transaction, but the qualified intermediary doesn’t get the benefit of interest income between transactions.
The cost can be worth it
There can be significant costs associated with a 1031 exchange. You can expect to pay a fee around $1,000 for a standard 1031 exchange, and the facilitator can earn thousands of dollars in interest income. If you had sold the property and held onto the proceeds, you could have made that money yourself.
Despite the costs, however, a 1031 exchange can be well worth it. A 1031 exchange can let real estate investors defer thousands or even millions of dollars in tax liability. So the costs of setting up and completing the exchange are a good investment.